At Bunri [Name withheld] Academy, it emerged that the founder's eldest daughter, who formerly headed the academy, had been rather freely spending the educational corporation's money.
The latest report follows a familiar pattern in tax matters.
The Regional Taxation Bureau determined that approximately ¥75 million in total—including travel expenses not recognized as business-related, stays at luxury hotels, and the cost of accessories purchased by the former head of the academy with a credit card in the academy's name—were “private expenditures that in substance constituted salary,” and pointed out that the academy had failed to withhold income tax. The additional tax assessment was ¥25.6 million, including heavy additional tax, and the academy commented, “We will have the former head of the academy bear the full amount” (TBS News, December 25, 2015 (Japanese)).
This time, I would like you to gain a comprehensive understanding once again of the tax issues that arise when embezzlement or misappropriation for personal use occurs at a company.
Expenses Diverted for Private Use Are Taxed
Unless embezzlement or misappropriation for personal use has been meticulously planned so that the company will not notice it, it is generally treated (deemed) as salary or a bonus paid to the person who embezzled or diverted the funds for private use.
This is judged quite strictly, and it can end up in court. Well, ordinarily the taxpayer loses, though...
If the money can be recovered through damages, taxation as salary and so on may sometimes be avoided. In this case, however, of ¥56 million in misappropriation for personal use, only about ¥15 million had been repaid to the school, and ¥41.3 million of the damage had not yet been recovered.
The reported case follows this pattern.
However, the former head of the academy presumably does not have that much in assets. The authorities claimed the amount from the school.
Withholding Is the Company's Obligation
When salary is paid, tax is withheld. Withholding is a system intended to prevent income tax from going uncollected and the like. It imposes the obligation to pay tax not on the taxpayer, but on the party making the payment.
After the misappropriation for personal use, the educational corporation is required to pay the national tax authorities the additional assessment, in a sense as an advance on behalf of the former head of the academy, and it will end up holding a claim against that former head that is likely to become a bad debt.
Adding insult to injury. But as company managers, let us recognize the risk in this lesson.
How the tax authorities respond when embezzlement or personal misuse of funds is discovered
Leaving aside the circumstances of the educational corporation in the report, the national tax authorities have a relatively varied range of responses in order to obtain tax payment somehow from wherever there is money. Let us look at them.
Treating the money as salary and assessing additional tax on the individual
This is the orthodox pattern of imposing additional income tax and so forth corresponding to the amount deemed to be salary for the individual. The point is whether it can be regarded as equivalent to salary. This also applies where the company knew what was happening but, for whatever reason, turned a blind eye. Late-payment interest and heavy additional tax may be imposed.
Assessing salary-related tax on the individual and additional withholding tax on the company
Where someone has diverted funds for private use and spent lavishly, that person may have no ability to pay. In principle, the amount of withholding tax can be recovered if the person files an income tax return, so where the person has the means, the national tax authorities gain or lose nothing. But when the person cannot pay, they can claim the amount from the company by invoking the fact that the company is responsible for withholding tax! The Bunri [Name withheld] case is this pattern. Late-payment interest and heavy additional tax may be imposed.
The company claims damages, includes the amount in taxable gross income, and pays the tax
A fairly common, ordinary pattern. Amounts diverted in the past have been processed as expenses, so the company treats the amount as income in the form of damages, pays the corresponding tax, and that is the end of it.
If it can be recovered, expenses and income balance out, so the damage to the company is not great. But if it cannot be recovered, it may put pressure on the company's cash flow because of the timing.
This is because the company pays tax on the amount as gross income for tax purposes when it makes the damages claim, and records a loss as a bad-debt write-off when it is determined that the damage cannot be recovered.
Fictitious Invoices Are Not Recognized as Deductible Expenses for Tax Purposes
Painful. This is painful.
It was learned that a former group manager, a woman in her fifties who had belonged to the technical division of Toshiba Lighting & Technology, a lighting manufacturer in the Toshiba Group (Yokosuka, Kanagawa Prefecture), is suspected of having repeatedly placed fictitious orders totaling at least ¥1 billion over at least 10 years and embezzled approximately ¥700 million.
The matter came to light in a tax audit by the Tokyo Regional Taxation Bureau. On the grounds, among others, that the fictitious orders could not be recognized as expenses, the company was found to have failed to report approximately ¥960 million over the seven years through the fiscal year ended March 2011, including approximately ¥32 million in concealed income.
The company has already suffered losses of at least ¥1 billion from the embezzlement.
On top of that, it is assessed tax corresponding to the ¥960 million for the seven years.
If the person who embezzled the money has no means and the funds cannot be recovered, the company has already suffered the pain of a ¥1 billion loss, yet, as if rubbing salt into the wound, about ¥400 million in tax corresponding to the ¥1 billion is added, increasing the loss to approximately ¥1.4 billion.
In the Toshiba Lighting & Technology case, incidentally, the actual tax paid was ¥28 million because the company happened to have carried-forward tax losses.
Late-payment interest and heavy additional tax may also be imposed in this case.
Reported Embezzlement and Misappropriation for Personal Use Are Only the Tip of the Iceberg
Reported embezzlement is only the tip of the iceberg.
When embezzlement is discovered, (1) the company's credibility with business partners and others declines significantly, (2) employee morale declines, and (3) various tax issues arise. Therefore, the basic approach is not to make it public, but for the company and the individual involved to seek a point of settlement.
A company that allowed embezzlement to happen probably had weaknesses of its own. A mature response is needed.
Discovery in a tax audit is a bad outcome: build systems to detect embezzlement early inside the company
Among cases that are reported, many are discovered through tax audits. Unless the case is the work of a very small number of highly sophisticated white-collar criminals, this can only mean that the company was not being managed well.
A corporate culture that allows employees to commit wrongdoing, and work procedures that permit wrongdoing. Management bears great responsibility. Employees who embezzle are human too, and anyone can have a moment of weakness.
Implement systems that prevent wrongdoing such as embezzlement and detect it early even if it occurs (this is professionally called internal control).
Certified public accountants are specialists in internal control, so if you need advice, asking a certified public accountant will surely resolve the matter in no time.
If a large amount of embezzlement is discovered in a tax audit, you are helpless, like “a carp on the chopping board.” Consult with a tax accountant and make your case so that the national tax authorities' assessment and penalties will be as light as possible. There is little else you can do.
Please aim to run your company so that you never find yourself in that situation.